Purchasing a business offers the advantage of not having to build a company from the ground. A business acquisition gives the new owner the capacity to operate from day one and have more probability of immediately receiving profit. Before buying a business, be aware of these 10 red flags that may affect your acquisition.
1. Unclear reason behind the business sale
One of the main questions you should ask the current business owner is why is the business on sale. If the seller does not want to disclose this information, this certainly is a red flag. But if, on the contrary, the owner is willing to give you his answer, you should examine his response.
If the answer is related to the owner wanting to retire or focusing on a business venture, then the business may be a good fit for you. When that’s the true reason for selling, the business owner can provide the customer base as part of the sale and you wouldn’t have to worry about competing against him.
On the other hand, if the owner’s reason to sell the business is related to financial problems or the incapacity of sustaining the business, then you should reconsider the offer.
Whatever the response may be, you can still gather more information by asking more relevant questions about the business purchase or during the due diligence process and decide the accuracy of their answer.
2. Financial inconsistencies
The financials of the business are one of the most important indicators that will help you determine if your investment is safe.
It is highly advised that you go back to the financial statements for at least three years, so you can have a clearer picture of the company’s performance.
Even when you are familiar with accounting, it is best practice to have a CPA do the audit so a third party can give an unbiased and accurate opinion of the business’s financials. Also, a professional will be able to identify issues that may pass unnoticed by anyone else.
Discrepancies in financial statements
It is usual that a business owner shares the supposed company’s revenues of the business and alleges they are in a good state, but once you make an inspection, the numbers are different from what you have been told.
When this is the case, it could mean two things: The first one, that the business owner is not being completely honest, or two, that the seller does not have a correct accounting of the company. Neither of these options can be beneficial for you.
You should take a careful look at the owner’s discretionary income, which is the cash flow made after the business expenses. Examine the consistency of the profits and losses so you can have a clear idea of the business’s risks and growth potential.
These figures will help you understand the source of revenue of the business. Inconsistency in these numbers may signify the company is directly subject to uncontrollable factors like the economy or advancements in technology. For this reason, it is better to opt for a business whose earnings are as predictable as possible.
You can encounter that the business has had declining sales figures. This does not necessarily mean the company is a dangerous bet, since this may facilitate a better purchase price, and then you can make a deeper analysis to resolve the problem. However, if this decline has been present for the long term, it is an issue that can make you reconsider the offer.
3. Poor credit scores and outstanding debts
An evident red flag is when your business transaction does not qualify for financing. Lenders will not be willing to finance a purchase that represents a high level of risk. When you ask for a loan, lenders will evaluate the potential profit derived from the business acquisition.
If the lender notices the business has financial or viability problems, likely, you cannot get a loan. This, more than a disadvantage for you, will prevent you from entering an unfavorable deal.
Usually, business owners ask for loans to boost the growth of their businesses. You want to make sure the business you purchase is free of debts so you are not held liable.
You can check the company’s credit score and history on websites such as Experian to verify whether the company has been struggling financially in the past.
4. Tax liability
It’s of the utmost importance that you verify if the target company has been punctually paying its taxes. The last thing you want to do is buy a business that will get you into trouble with the IRS.
Examine the federal and state tax returns for the last three years (at least) and verify if they are consistent with the company’s financial statements.
Give extra care to sales tax. Local businesses often underreport income to minimize their tax expenses, which can bring huge liabilities if you have a state audit after the transaction.
Unless you want to end up paying unexpected penalties, consider receiving support from an accountant to ensure the tax filings are in order.
The IRS website may help you find out if a business owes back taxes.
5. High employee turnover
A company gains most of its value from its employees. A visible concern is when employees are frequently terminated or decide to quit. The average turnover varies depending on the industry, so you should evaluate if it is higher than usual.
High employee turnover indicates serious underlying problems, such as poor employee management, a negative work environment, poor salaries, or difficulty attracting and retaining good employees.
Employee satisfaction is key, you want to keep your workforce by your side after the business acquisition to start operating. Besides, your employees are going to be your support and educate you in the business for the next 12-18 months following the transaction.
You can also ask an employee directly about the experience they have had working with the target company. Take this opportunity to gather more information on the benefits and pay structure they receive and analyze whether you will be able to match it to your prospected business model.
6. Unsustainable business model
Although the financials of a business appear to be healthy, you need to take a deeper look at the overall business model structure. The reasons behind the apparent success of the company may be tied to the owner rather than good management of the company.
Another possibility is that although the company has enjoyed stability until now, it is not prepared for future changes in the industry.
You need to analyze whether the foundations of the company are solid, even when you take some factors out of the equation.
Here are some situations that could affect the profitability of the business:
Reliance on a few customers and suppliers
A company may be sustained by only a few customers for some reasons: They are personally related to the business owner or they are loyal to the company out of tradition or commodity.
It is also possible that the business has few repeat clients, which may signify a low-quality service or a weak relationship with customers.
Similarly, the operations of the business are put at risk when it relies on a single vendor. A business owner can’t afford to be subject to several external factors that could seriously affect the profitability of the business.
Deficient growth potential
You need to be aware of the direction of the industry from a high-level and local perspective. Is it in decline? Is it stable? Are there external factors that threaten the business? Consider doing market research and analyzing if the target audience will continue to be broad enough to be profitable.
Be aware of the competitors in the space, as well as the demand for what the business is offering.
7. Included assets are not in a good condition
You need to know exactly what assets are going to be included in the business acquisition. You should look carefully at the condition of the physical and intangible items of your purchase. There are a few problems that you could encounter:
It does not sound like a good idea to invest in a business whose equipment is not in a good condition and needs to be replaced. Make sure the furniture and appliances of the business are usable. However, if this is not the case, you can compensate for the expenses of renewing the physical assets by negotiating a lower purchase price.
The inventory must be carefully examined to ensure it is not obsolete or has poor quality.
It is also substantial that the business keeps an accurate record of the inventory pieces. If the records do not match the existing pieces, it could mean the accounting procedures are not correct.
8. Bad reputation
Verify the reputation of the company and what is the general opinion of the customers towards it. You can have a better understanding of how people see the business by looking at Google reviews, social media posts, testimonials, and other sources. Also, employees can give you another perspective on the business.
Once the company is yours, you are going to be tied to its past problems, so you better look carefully at the actions that may later retail against you. Opting for a rebranding is a process that takes time and money, so it’s better to buy a business that already has positive brand equity.
9. Legal problems
You don’t want to buy a business that will immediately put you in legal trouble. A company that has past litigation issues or does not have the proper structure is an evident red flag when buying a business. There may be some underlying issues that are not so easy to spot.
Consider the help of an M&A attorney to ensure the company you are about to buy complies with the licenses and regulations of its industry, does not have pending lawsuits, is collecting customer data according to the law, and has its contracts in place.
A business attorney will be of great help in the due diligence process because she will let you know the risks of your business purchase and write a purchase agreement that protects you from the liabilities she discovered.
10. Untrustworthy business owner
Sometimes, you won’t even have to look into the business to realize something is off with your deal.
If an owner is not too cooperative, or reluctant to disclose information about the business financials and tax returns, this could mean he is withholding information that can affect you. It could also signify that the owner does not feel safe sharing this information, but you can always sign a Non-Disclosure Agreement to ensure your confidentiality.
Similarly, if you find out certain numbers or aspects of the purchase are not as the owner claimed, you surely don’t want to continue negotiating with a dishonest counterparty.
Another red flag is when the business owner puts so much pressure on closing the deal. The owner should give you a proper amount of time for you to carefully conduct due diligence and examine every detail of the business you are about to purchase.
By following the right process to buy a business, you can always withdraw from the negotiation before signing a purchase agreement.
If you have encountered one or more of these red flags, it doesn’t mean that you should walk away from the deal. However, you should analyze your options and work along with your business attorney who will take the necessary measures to limit the liability of your purchase.